Of Wealth Effects and Greater Fools

There’s one thing that seems clear after this week: The Federal Reserve is going to keep pumping the markets up until all the bears and shorts are squeezed out, and all that’s left are the greater fools.

“If someone tells me that the U.S. market is primarily being driven by genuine economic factors…I have to sit in my chair and sigh,” Michael Oliver of the research shop Momentum Structural Analysis, wrote. “I won’t argue, but I will sigh.” The market is being driven right now by Fed policy, and faith, he said. “This is a unique historical market situation…make no mistake of that.”

Mr. Oliver said that as a technically driven analyst he has to ignore his observations about the fundamentals. “Until and unless the massive momentum trend-defining structures below the market get broken - especially quarterly and annual – then this ‘bull’ trend remains on track. That is MSA’s opinion. Regardless of reasons, sustainable or otherwise.”

The Fed policy is certainly having one effect: The shorts are getting crushed this year, because Fed policy has made just about everything a winning bet. Momentum stocks like Tesla and Netflix have quadrupled. Stocks like Green Mountain and Herbalife are battering the shorts. Short activity is down by about half this year. What’s left is a market that’s betting prices will be higher tomorrow than they are today, and that there will be a willing buyer tomorrow. In investing circles, it’s called the greater fool theory, and it drove the markets during the latter stages of the dot-com boom and the housing boom.

“Remember 1999, when markets ripped through Q4 because so many investors had bided their time waiting for the dot-com bubble to collapse earlier in the year?” Nicholas Colas, the chief market strategist at ConvergEx, wrote. “Cue the music, because this is beginning to look like the same market setup.”

Even despite today’s modest losses, the go-go, buy-everything market that’s defined 2013 got a fresh life. The Dow is up 19% this year, the S&P 500 is up 21%, and hardly anybody dares whispers “correction,” much less actually bet on one by shorting the market. But the so-called wealth effect looks more like a placebo effect.

Fed policy has been good for the markets, because the markets are the Fed’s transmission mechanism. After all, you don’t see central bankers standing on street corners handing out money (although, in a world of “unconventional” policies, that isn’t necessarily a bad idea). The whole wealth-effect notion behind quantitative easing relies on the markets: The Fed creates credit, uses it to buy bonds from the banks, and the banks use that money to lend. Business expand, consumers spend, the economy grows, and off we go on our merry, prosperous way.

It hasn’t quite worked out that way. The banks have generally parked that money on the Fed’s balance sheet. There’s been some activity: cheap credit has fueled a surge in auto sales, and sparked a modest rebound in housing. But mostly the Fed’s money has just propped up asset prices. Economic growth has been halting, and most people have seen no improvement in their wages. Even in a world where fundamentals don’t seem to matter, they still do, and nothing is more fundamental to economic growth than wages.

Wages are largely flat, and if inflation ever does pick up, wages will likely fall in real terms. Meanwhile, the Fed keeps pumping, and ratcheting up the risks.

“The longer Main Street takes to recover, the greater the risk of asset bubbles,” Michael Hartnett, the chief investment strategist at BofA/Merrill Lynch, wrote in his weekly Thundering Word note.

At the current rate of recovery, another bubble seems inevitable. But try telling that to the greater fools.